Buying a stock is probably the easiest part of the investment process. Once you've found an opportunity and done all of the due diligence that you believe is required to establish whether or not the company is undervalued, clicking "buy" at the right price does not take much effort.
It is much more challenging to decide when to sell. You may have a game plan when you first enter a position, but there's no guarantee that the situation will remain the same throughout the duration of the trade. The situation will likely change over time, and you have to be prepared to adapt to this.
Being able to continually re-evaluate and adapt your investment plan to the changing market environment is challenging. It's made even more difficult by the fact that there's no right or wrong answer. As investors, we have to acknowledge that 90% of the time, the price we sell and buy at will be incorrect.
Still, that doesn't mean we shouldn't try to understand the process of selling and develop our framework for buying and selling securities, as well as keeping up to date with market movements.
When to sell
When it comes to deciding when to sell securities, Warren Buffett (Trades, Portfolio) has an elementary rule. He makes sure he buys only stocks that he will never need to sell; that way he never has to answer the question.
"Well, the best thing to do is buy a stock that you don't ever want to sell," is how the Oracle of Omaha replied to one audience member at the 1998 Berkshire Hathaway annual meeting of shareholders who asked him if he could outline the criteria Berkshire uses to decide when to sell a stock.
But planning this way can only get you so far, which is what Buffett went on to acknowledge. Another reason why you might want to sell a stock is because a better opportunity comes along, he said. In this situation, it is perfectly acceptable to turn your back on a stock you want to hold forever. Here's what Buffett had to say on the matter at the 1998 meeting:
"Sometimes, if we need money to move to another sector like we did last year, we will trim some holdings, but that doesn't mean we're negative on those businesses at all. I mean, we think they're wonderful businesses or we wouldn't own them. And we would sell A, if we needed money for other things.
"The GEICO stock that I bought in 1951, I sold in 1952. And it went on to be worth a hundred or more times -- before the 1976 problems -- 100 or more times what I'd paid. But I didn't have the money to do something else. So you sell if you need money for something else."
Another strategy the CEO of Berkshire Hathaway advocates is top-slicing or taking a certain amount of profit off the table with a security if it becomes seriously overvalued:
"You may sell if you believe the valuations between different kinds of markets are somewhat out of whack. And, you know, we have done a little trimming last year in that manner. But that could well be a mistake. I mean the real thing to do with a great business is just hang on for dear life."
When he handed the microphone on to Charlie Munger (Trades, Portfolio), the vice-president of the Berkshire added that the "ideal" time to sell a stock "is when you've found something you like immensely better."
The main takeaway from this commentary is that investors should be looking to find stocks that they don't need to sell in the first place. That way, they never have to deal with the difficult question of when to sell. If you own something you never intend to sell, you only need to consider exiting when you've found something better.
Disclosure: The author owns shares in Berkshire Hathaway.
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